Advanced Dynamic Allocation

Advanced dynamic allocation for the hedge fund investor

BNP Paribas
Originally published in the September 2005 issue

Most investors are seeking products that offer strong return potential whilst minimising risk to capital. Structured products provide such a solution. Better known for providing exposure to equities, equity indices or fixed income instruments, structured products can also be linked to less traditional asset classes, such as hedge funds. By using hedge funds as the underlying asset, investors are offered a unique combination of benefits, including attractive risk-return profiles, low sensitivity to traditional benchmarks, good performance in hostile markets, risk diversification and structuring flexibility. Leverage can be used to enhance returns relative to direct investment in funds, and initial capital invested can be fully or partially protected.

Structured products can be linked to a broad universe of hedge funds, allowing investors to tailor their levels of risk, return and volatility through strategy allocation, identify and select top-performing fund managers, and access otherwise unavailable funds.

Structured products on hedge funds can be created to offer full or partial capital protection. The capital protection is backed by an investment bank such as BNP Paribas, rated AA by Standard & Poor's and Aa2 by Moody's. Alternatively, a third party issuer can be used to back capital.

There is also scope for diversification, as whilst structured products can be linked to individual funds, there is also the opportunity to link to a basket of funds. This may provide multi-asset, multi-style and multi-manager exposure.

Such baskets of funds can be actively managed to achieve strong performance. The aim is to create switches between different asset classes, for instance hedge funds, money markets and cash. Typically, the basket will alternate between high risk premium asset classes (growth asset) and low risk premium asset classes (defensive asset). Simply, exposure to both assets is increased or decreased according to their relative performance during the investment lifetime. The target is to have a high allocation to the growth assets in favourable market conditions whilst relying on defensive assets in volatile market conditions in order to ensure capital preservation.

This dynamic allocation process is embedded in structures such as Constant Proportion Portfolio Insurance (CPPI) and Option on a Dynamic Basket (ODB). These structures maximise equity exposure when markets are rising and overweight defensive assets such as bonds when stock markets are weak. Structured products on hedge funds can also provide leveraged exposure -usually up to 150%- to the fund or basket of funds to meet the needs of more aggressive investors. Leverage increases exposure (and also volatility) to the underlying assets, and therefore should result in enhanced returns.

Constant Proportion Portfolio Insurance (CPPI) structures

As a precursor to ODB structures, CPPI structures are suitable for investors looking to boost their investments without putting capital at risk. CPPIs actively allocate assets over time to pursue maximum performance and safety of capital. The dynamic investment strategy facilitates high exposure to growth assets when markets rise, and overweight defensive assets in unfavourable conditions. Therefore, participation in the fund component is not pre-defined, but increases according to its performance.

The basic structure uses a dynamic basket as the underlying asset, which is composed of a growth asset and a defensive asset. Growth assets can include a wide range of funds, and are most likely to be equity funds. The main objective when selecting the defensive asset is to have a strong alternative that would support the product if the growth asset should perform unfavourably. During the investment lifetime, exposure to the growth asset increases or decreases, according to the relative performance of the basket value and a zero-coupon bond reference line.

The total basket value must not fall below the reference line, which represents the present value of the minimum amount to be paid back to investors at maturity. If the basket drops sharply and reaches the reference line, it is then fully invested in the defensive asset to protect capital. Thereafter, even if the growth asset then rallies, the basket will permanently maintain a full investment in the defensive asset.

This risk of being irrevocably invested in defensive assets in sharp market declines has led to many CPPI funds 'cashing-out', prompting the dynamic management process to evolve by ensuring permanent non-zero exposure to the underlying growth asset with products such as the Option on Dynamic Basket.

Option on Dynamic Basket (ODB) structures

An ODB offers a new generation of pay-off profiles combining an option structure and CPPI's dynamic allocation technique. A high degree of flexibility and the ability to customise products are key advantages of ODBs.

With an ODB, the dynamic allocation to growth assets can be over 100% via leverage, whilst always providing for a minimum degree of exposure to the growth assets to avoid total disinvestment in the event of adverse basket performance. This is an improvement compared to the CPPI where the full portfolio may end up in cash under unfavourable market conditions.

This is also an improvement compared to an option. The adjustable exposure to the volatility of the growth asset and the possibility of leverage during the product lifetime serve to increase the potential returns compared to returns from an option. An ODB costs less than an equivalent vanilla call directly based on the underlying, therefore allowing higher participation rates in the ODB pay-off.

The ODB is a structure composed of two parts, a cash instrument intended to provide the desired capital protection and an Option on a Dynamic Basket, which provides return at maturity:

Unlike a traditional call option referenced to an underlying fund or basket of funds, an ODB is a call option on a dynamic basket, which actively allocates between a growth asset and a cash asset. Initial allocation to the growth asset is set at a certain level (usually 100%) at inception. During the investment lifetime, it increases and decreases according to the distance between the basket value and a reference line (zero-coupon bond line or fixed line).

Target participation is calculated daily as a function of this distance and a chosen leverage factor. Whenever the difference between the current participation and target participation exceeds a defined range, the participation is readjusted to the target participation.

The target participation is floored at a minimum, and capped at a maximum participation level (usually with leverage, at an additional cost). As a result, there is no total deleverage into the defensive asset and no 'cash-out' phenomenon. Under favourable market conditions, the ODB structure permits more than 100% participation in the growth asset, enabling investors to benefit from this geared exposure without having to seek external sources of leverage.

ODB structures add a new investment dimension to structured products on hedge funds. A lot more flexible than CPPIs, they allow investors to create their own portfolio strategies and tailor their selection of underlying assets, asset allocation strategy and option pay-off.

The underlying basket may be customised in accordance to the investor's objectives by selecting the relevant growth and defensive assets. Return on the ODB investment will be enhanced if the investor's chosen growth assets achieve strong performance, but remain protected if the wrong market calls are taken.

Once the growth and defensive assets have been selected, the asset allocation between the two can be defined. Different parameters such as the reference line, the leverage factor and the minimum/maximum levels of exposure to growth assets can be chosen according to investors' views on interest rates and underlying markets. For instance, the mechanism of reallocation can be de-coupled from the zero coupon bond reference line, and can instead be determined via a fixed or accreting line chosen according to investor views, thus avoiding the impact of interest rates within the reallocation process.

The versatility of ODB is reflected in the different ODB product variations available. Products which are also available for CPPIs, include the 'look-back' ODB, which secures returns by redeeming at maturity a pre-defined percentage of the highest basket value observed since inception, the 'lock-in' ODB which locks-in a percentage of the basket's performance each year, and the 'coupon' ODB, which allows investors to receive regular payments throughout the product's life. Other products more specific to ODB include the 'Asian' ODB, which smoothes the basket's performance by sampling the underlying at set intervals, and the 'Quanto' ODB, which offers investors the opportunity to receive at redemption the value of the ODB in a different currency to that of the underlying asset, thus offering protection to exchange risk.

ODBs have added a new dimension to structured products, offering a variety of leveraged pay-offs and highly flexible underlyings, based on quantitative and risk-controlled parameters, whilst securing the preservation of capital at maturity.

Options on Dynamic Baskets aim to maximize exposure to the growth asset when it performs, whilst protecting performance in periods of poor growth asset returns. ODBs are suited to investors seeking access to alternative asset classes and looking to benefit from enhanced yield- an appealing package in itself. Moreover, ODBs' ability to overweight fund assets and benefit from self-financed leverage, ensure a minimum degree of exposure, obtain attractive premium levels and tailor their option pay-off, ensures that it will remain a firm favourite for investors over the next few years.

Main benefits of ODB

  • Participation increases with strong performance in the growth asset.
  • There is no risk of being permanently invested in cash in the event of under-performance of the growth asset, as there is a minimum degree of exposure to this asset at all times regardless of any fall in interest rates or adverse performance.
  • The defensive asset can be chosen from different sources: variable rate (eg Euribor), zero coupon bond or a pre-defined fixed rate.
  • There is a possibility to offer leverage at inception.
  • An ODB is cheaper than a call option on the growth asset alone, so higher leveraged participation to the growth asset's performance is possible (subject to deleverage risks).
  • Capital protection is provided at maturity.